Unlicensed entities are managing people’s money in a thriving racket, exploiting the very provisions the market regulator has put in place to protect small investors, market participants say.
Some of the regulations make it difficult for a small investor to profit from complex trading strategies that promise superior returns, albeit with greater, unstated risk. Regulated money managers cannot freely engage in high-risk trades these unlicensed entities do.
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Regulatory Catch-22
If an investor wants another entity to manage his/her money, there are three specialists he/she may approach—a Mutual Fund (MF) house, a Portfolio Management Service (PMS) or an Alternative Investment Fund (AIF).
The best mutual funds indicate a return potential of 15% (pre-tax) return. The unregulated entities dangle potential returns of 20-30% and the more unscrupulous ones promise multi-bagger returns.
A PMS or AIF indicate a potential return of 20-30%, but the minimum investment limit keeps small investors out.
“I would say that this problem (of unlicensed money managers) really took off after the PMS limit was raised from Rs 25 lakh to Rs 50 lakh (in November 2019). What would people with lesser capital do,” said Vivek Bajaj, co-founder of Elearnmarkets, which offers courses in investing, and the stock market app StockEdge.
To invest in AIFs, clients need a minimum capital of Rs 1 crore.
A market insider who did not want to be named said PMS managers themselves are known to approach these unregulated money managers, because the latter can engage in certain kinds of trades the regulated services can’t.
“PMS managers can use derivatives only for hedging (or portfolio rebalancing) but they can’t use it purely for trading or for taking naked calls (when an investor does not own the underlying security and he/she trades in the option to profit from the premium),” this person said.
There are other restrictions on PMS managers too such as limits set on investments in unlisted securities.
To trade in derivatives, an investor could approach an AIF manager because there are products under Category III of Alternative Investment Funds that are purely derivative-based and aim for short-term returns by using complex trading strategies.
But AIFs cannot engage in highly leveraged trades that some unregulated entities offer.
“In AIF-III, you cannot have more than 2x leverage. This can be highly restrictive (in terms of the high-risk, high-reward trades you can undertake, such as deep out-of-the-money call or put option),” the person cited above said.
According to an FAQ document released by the Securities and Exchange Board of India (SEBI) on the regulations that govern AIFs, “the leverage of a Category III AIF shall not exceed 2 times the NAV of the fund.” NAV is short for Net Asset Value.
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Despite these restrictions, experts recommend that investors only approach regulated entities.
“As a customer, if anything goes wrong, you can file a complaint. But if you buy a service from an unregulated entity, then even the courts may ask you why you approached such a person or organisation. The customer may not be penalised for approaching an unlicensed manager, but the customer won’t get legal redress either,” said Bajaj.
Aashish Somaiyaa, CEO of White Oak Capital Management, said: “Complex investing strategies can be set up in regulated entities such as the AIF-III, but such strategies are meant for investors who can appreciate their complexities, can absorb the volatility involved in such strategies and the risk associated with it. Investors with smaller capital may not be able to tolerate the capital risks or the complexities associated with these. Therefore, the regulations are definitely good.”
“Irrespective of the size of investment or the structure of regulated products, scamsters peddling unlicensed services would try to find loopholes and the answer is investor awareness and legal action against unlicensed actors,” he added.